Valeant is about to hold the most intense investor call in years — here are the questions they must answer

Not since the financial crisis has a multibillion-dollar company
seen its fortunes change as quickly as Valeant Pharmaceuticals.

In the past week, questions have emerged about its business
practices that surprised investors and analysts who follow the
Canadian drugmaker, and the market's response has been brutal
— about $20 billion was erased from the company's market
value in just five days.

On Monday at 8:00 a.m. EST, the company will hold a conference
call to respond. How the company handles that call will determine
the narrative for the foreseeable future.

To calm investors, Valeant will have to explain the details of
its relationship with the specialty pharmacies: How many of them
exist under Valeant's umbrella and which of them does it own
directly; how are they operated; and, how is their revenue
accounted for.

Analysts aren't sure about any of these, even though the
specialty pharmacies — which seem to lean on a massive
telemarketing operation to push Valeant's products — could
account for more than 10% of the drugmaker's sales.

After all, many investors never even knew that Valeant owned any
specialty pharmacies until last week. Until then, they were a
secret.

Out with it

Doubts surrounding Valeant's business model have been floating in
the ether for about a month, with politicians from Sen. Claire
McCaskill (D-MO) to House Democrats asking questions about its
pricing practices.

Those questions
mounted on Monday, when Valeant revealed that it is the
partial owner of a firm called Philidor.

Philidor distributes Valeant products exclusively and Valeant
integrates Philidor's revenue into its own balance sheet. Valeant
also has the option to buy the specialty pharmacy, which in the
last few years has grown to 700 employees in Pennsylvania and
Arizona.

Valeant also revealed that Philidor is engaged in a lawsuit with
another member of its network, R&O — a California-based
specialty pharmacy. Valeant says R&O owes it $69 million in
sales. R&O says Valeant has never billed it.

"Based on our understanding, 10% of Valeant’s revenues come from
specialty pharmacies. While other companies also use specialty
pharmacies, the structure of Valeant’s network seems different,"
wrote BMO.

"In the case of Philidor, Valeant consolidates their financials
and seems to have a controlling financial interest, while other
companies say their affiliated specialty pharmacies are 'fully
independent.' Valeant’s structure may not be illegal, but we find
it aggressive and questionable."

This screams uncertainty, so it's not hard to see why investors
are heading for the exits. To stop them, Valeant has to lay out
some detailed answers.

How many specialty pharmacies exist in your network and where are
they licensed?

Philidor operates in 46 states and Washington, D.C., but it does
not operate in California. It was denied a license to operate
there by regulators in May 2014.

Government documents show that Philidor's application was
denied because Matthew Davenport, brother of Philidor CEO Andy
Davenport, made false or misleading statements regarding the
nature of Philidor's ownership structure and who's responsible
for its accounting.

Still, two companies operated by Philidor employees and
executives, called Lucena and Isolani, managed to take 10% stakes
in a pair of California pharmacies — West Wilshire Pharmacy
and R&O respectively. In its incorporation documents, Isolani
discloses that it was
formed for the sole purpose of purchasing R&O.

But to do this, Philidor employees were asked to disclose whether
they were affiliated with a pharmacy that had its application to
operate in the state denied. In both cases, employees said they
were not.

Considering the legal risk, investors will probably want to know
if there are any more of these LLCs and pharmacies out there and
what their ownership structure is like.

Are pharmacies in your network using each other's credentials to
sell product?

R&O alleges Philidor was pressuring R&O's owner and
pharmacist-in-charge, Russell Reitz, to sign off on fraudulent
audits, according to filings related to a lawsuit between the
companies. At issue in the suit is that R&O is withholding
payments that it owes Philidor.

According to Reitz the story goes like this: Philidor approached
him in the fall of 2014 about the sale of his pharmacy. The two
parties made a deal in which Philidor gave Reitz 10% of the
$350,000 sale price up front and would pay the rest when certain
conditions were met.

One of those conditions was the approval of Isolani's pending
California pharmacy licensing. In the meantime, Philidor would
take over most of R&O's businesses operations while Reitz
still signed off on sales.

Reitz alleges that Philidor never disclosed its relationship with
Valeant, or that it had an application for a California pharmacy
license denied. A few days before the sale, Philidor created
Isolani, and the R&O deal was done through that entity.

Court documents show that Reitz started asking questions this
spring and summer — questions about the relationship between
Philidor and Isolani. He also accused Philidor employees of using
his pharmacy's credentials with insurers to process sales from
other pharmacies, some from even before R&O was sold to
Isolani.

Philidor CEO Andy Davenport responded to that accusation by
saying in an email that Philidor would stop using R&O's
credentials.

Evercore

Reitz alleges that Philidor didn't stop using his credentials
after that email, and that is why he started withholding cash
from Philidor.

So the question is: Are credentials shared across
Valeant/Philidor's special pharmacy network? If so, why?

How much of Valeant's sales are driven through specialty
pharmacies?

On last Monday's earnings call, Valeant CEO Michael Pearson said
that specialty-pharmacy sales accounted for about 10% of his
company's revenue.

But he seemed a little unsure about it (from the call transcript,
emphasis ours):

David Risinger - Morgan Stanley - Analyst: That's
great. And then just separately, you discussed alternate
fulfillment, could you just put that in perspective, maybe
what percentage of the US brand Rx business alternate
fulfillment is and how much of that is Philidor?

J. Michael Pearson - Valeant Pharmaceuticals International,
Inc. - Chairman and CEO: Sure. It's really primarily our
dermatology brands and then some of our specialty products like
Ruconest, Arestin, and some of the other orphan drugs. For
certain products it's quite large. For Jublia it's probably 15%.
For a lot of other dermatologies it's much less. I'm sorry, I
can't — it's significant but it's — I don't
know the precise number but it's certainly, of our US portfolio,
10%, 20%, maybe. Tanya's nodding probably closer to 10%.

Now that it seems Philidor's network may be more extensive than
we thought, investors will likely want a breakdown of those sales
and how they contribute to Valeant's bottom line.

Both on Monday's call and in a letter to Sen. Claire McCaskill
earlier this month, Valeant said that it spent $525 million on
PAPs and CAPS in 2014 and that it expected to spend $1 billion
going forward.

These programs help subsidize the cost of drugs for patients
whose insurance programs don't include them. This is especially
important in Valeant's case, since many of its drugs — especially
the ones Philidor distributes — are not life or death. They treat
things like acne and toe fungus. Valeant

But another alarm here is that none of this CAP or PAP spending
is broken out in Valeant's earnings reports.

It's also unclear how those funds are administered. Normally the
funds are put in a pool with money from other drug companies and
administered through a third party, which disperses them
accordingly.

When asked about it last Monday, Michael Pearson was unclear
about how that worked. He was also interrupted by his staff.

From the transcript (emphasis ours):

Doug Miehm - RBC Capital Markets - Analyst: Thank you.
Couple questions, as well. Number one, with respect to
patient access and foundations, maybe you could walk us through
how many foundations you fund. And of those foundations what
proportion of their annual operating budget would you provide to
them? The second one just has to do with, if you were to
split out the US neuro business, can you give us a sense of what
EPS contribution or EBITDA contribution that business would have?
And I'll leave it there.

Laurie Little - Valeant Pharmaceuticals International, Inc. -
Head of IR: Why don't you concentrate on just a couple right
now. We're trying to get through everybody. So, why don't we
answer the --.

J. Michael Pearson - Valeant Pharmaceuticals International,
Inc. - Chairman and CEO: Okay. I don't have a
precise number but it's like four or five, so it's a small
number. We make sure, as we mentioned, that other companies are
also contributing, or other organizations, at least, are also
contributing. We do not want to be the only one to contribute.
Again, we just give them the money and they do what they want to
with that money. I don't want to give you a precise
figure in terms of what percent of our funding because I don't
have that and I don't want to guess. Next question.

If Pearson isn't clear on it, investors certainly aren't either.

And it's only natural that after everything that's happened,
investors will want to know how Valeant's specialty pharmacies
are operated and their sales subsidized.